Reading the Markets

Sunday, February 17, 2019

Niall J. Gannon, of the Gannon Group at Morgan Stanley, is a financial advisor for high net worth and ultra high net worth individuals and families. And yet Tailored Wealth Management: Exploring the Cause and Effect of Financial Success (Palgrave Macmillan) is applicable to all investors, at any stage of their lives. It addresses three pillars of wealth: identifying and building it, managing it, and deploying it. As such, the book can be read as a wealth life plan.

Among the most original parts of the book is an updated version of a paper Gannon co-authored with Scott Seibert in 2006. It has been re-titled “Forecasting Long-Term Portfolio Returns: The Efficient Valuation Hypothesis.” The paper’s hypothesis is that “much of the long-term (20-year rolling periods) variability in stocks can be explained by the beginning-of-period earnings yield (the inverse of the starting P/E ratio).” For the 42 rolling 20-year periods beginning on January 1, 1957, with the inception of the S&P 500, the paper shows that the earnings yield accurately predicted the minimum expected return 95% of the time. In the two instances in which the hypothesis failed (1958-1977 and 1989-2008), the disparity was less than 1%. It is noteworthy that the highest observed earnings yield of 13.7%, in 1975, produced a 14.33% annualized return and the lowest earnings yield of 4.54%, in 1998, produced a 7.1% annualized return. Gannon concludes that “the use of earnings yield as a minimum expected return produces a more informed comparison of the future return potential of equities versus fixed income than the application of the theory of mean reversion or the Efficient Market Hypothesis.”

Gannon looks at the effect of taxes on equity returns and tries to compare stock and bond returns on a net basis. He contends that “the notion that stocks outperform fixed income over time … is false when examining net returns over specific periods.”

Tailored Wealth is a valuable book both for financial advisors and DIY investors. Most of it is easy-to-read text, with the occasional case study thrown in to illustrate the pillars of wealth. But it includes just enough quantitative research to whet the appetite of anyone who is trying to plan his or her financial well-being for the long run.

Sunday, January 13, 2019

Shoshana Zuboff, professor emerita at Harvard Business School, has the rare ability to take a subject that has been beaten to death and offer a fresh, provocative take on it. The Age of Surveillance Capitalism: The Fight for a Human Future at the New Frontier of Power (Public Affairs/Hachette, 2019) is such a work.

First, a brief description of surveillance capitalism. It “unilaterally claims human experience as free raw material for translation into behavioral data. Although some of these data are applied to product or service improvement, the rest are declared as a proprietary behavioral surplus, fed into advanced manufacturing processes known as ‘machine intelligence,’ and fabricated into prediction products that anticipate what you will do now, soon, and later. Finally, these prediction products are traded in a new kind of marketplace for behavioral predictions that I call behavioral futures markets.”

Even more dangerously, automated machine processes not only know our behavior but also shape our behavior. “With this reorientation from knowledge to power, it is no longer enough to automate information flows about us; the goal now is to automate us.”

In this nearly 700-page book Zuboff develops her thesis using Google, Facebook, and Microsoft as “the petri dishes in which the DNA of surveillance capitalism is best examined.” Her discussion is wide-ranging, from Giovanni Gentile to B. F. Skinner to Alex Pentland (the MIT applied utopianist).

Zuboff is especially concerned about the damaging social and political ramifications of surveillance capitalism. It is, she writes, a “profoundly antidemocratic social force.” It is a market-driven coup from above, a “form of tyranny that feeds on people but is not of the people. In a surreal paradox, this coup is celebrated as ‘personalization,’ although it defiles, ignores, overrides, and displaces everything about you and me that is personal.”

The Age of Surveillance Capitalism will undoubtedly be a deeply divisive book, somewhat along the lines of Thomas Piketty’s Capital in the Twenty-First Century, which Zuboff cites. But it is an important read, one that makes us rethink our all too easy acquiescence to the siren call of surveillance capitalism.

Wednesday, January 2, 2019

When Harriman House announced the publication of the “definitive edition” of Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds, I wondered what made it stand out from all the other editions of this classic work. I don’t have the definitive answer myself, but I can say that, unlike many other versions, this one is complete. It contains not just the first three chapters, the ones dealing most directly with markets, but the full 15 chapters. Thus you can learn not only about money mania, the South-Sea bubble, and tulipomania, but about, among other things, modern prophecies, the influence of politics and religion on the hair and beard, the witch mania, haunted houses, popular admiration of great thieves, and duels and ordeals.

When I first read the abbreviated version, I thought I had absorbed everything Mackay had written that was relevant to the phenomenon of manias today. But, as Russell Napier notes in his preface to this new edition, “Not only has the world shown no signs of being immune to the errors within this book almost 180 years on, there are a number of trends today that make it even more pressing. The theme that runs through Mackay’s catalogue of follies is a search by reasonable people for an answer to uncertainty—sometimes, if necessary, by disregarding reason.”

Some of the things Mackay wrote about no longer seem especially relevant, although Donald Trump’s preoccupation with the phrase “witch hunt” might belie this point. Still, even though the specific delusions may change, the phenomenon of the madness of crowds remains in full force. And with social media, it may be even greater than it was in Mackay’s time, which makes his classic a must-read book in 2019.

Thursday, December 20, 2018

A heads up to anyone who wants to understand how some very bright quants think. I just downloaded AQR’s anthology commemorating its 20th anniversary. It’s big, coming in at nearly 700 pages, and free for the taking in either .mobi or .epub formats. Personally, I can’t think of a better way to spend part of the holidays than reading the 20 papers that “have formed the backbone of AQR’s investment philosophy.”

Wednesday, December 12, 2018

Bruce I. Jacobs’ Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes (McGraw-Hill, 2018) attempts to identify the common causes of financial crises since the 1980s. Jacobs, the co-founder of Jacobs Levy Equity Management and its co-chief investment officer and co-director of research, believes that underlying all of these crises have been “free lunch” products that, in turn, have their roots in the Black-Scholes-Merton option pricing model.

Jacobs focuses on three crises and the allegedly risk-reducing, return-increasing strategies and products that led in these cases to market instability and massive losses, at least in the short term. “Of particular interest are portfolio insurance in the 1980s, arbitrage strategies pursued by LTCM in the 1990s, and the mortgage-linked securities at the center of the 2007-2008 credit crisis.” Jacobs contends that they share certain commonalities. “These commonalities include opacity and complexity, which make it difficult to anticipate the effects of the strategies and products and to discern the relationships they forge between different market participants. They also include leverage, facilitated by derivatives and borrowing, which increases their impact on security prices, markets, and the economy. And they include the underlying, option-like nature of the strategies and products, which can make markets behave in nonlinear ways, with prices bubbling up or crashing down.”

One of the major problems with products that purport to reduce risk and increase returns is that they tend to encourage more risk-taking since people believe that, with these products, they have a safety net come what may. Moreover, as the demand increases for such products, “the level of risk that must be shifted increases. The availability of counterparties to take on the risk becomes more and more questionable. Liquidity begins to dry up.”

Jacobs does not argue against option, arbitrage, and securitization strategies in general. He recognizes that they can play a useful role in portfolios. He also recognizes that the crash-inducing strategies and products of the future will be different from those that caused problems in the past. He remains convinced, however, that they will share the same fundamental characteristics. Forewarned is forearmed.